ETFs: What you need to know

Exchange-traded funds are cheap, tax efficient, but mind pitfalls

SAN FRANCISCO (MarketWatch) — About $819 billion was invested in U.S. exchange-traded funds at the end of August. Was any of your money there? If not, you may be wondering if you’re missing out.

ETFs are mutual-fund hybrids that usually track indexes, just as traditional index funds do, yet they’re often cheaper and more tax efficient than some index funds. And they offer investors flexibility and access to more market sectors. But ETFs also come with a few twists that may tie you up.

The average ETF expense ratio is 0.6% of assets, compared with an average 0.8% for traditional index funds, according to investment researcher Morningstar Inc. Of the 64 traditional index mutual funds that track the Standard & Poor’s 500-stock index, the average expense ratio is about 0.4%, excluding funds aimed at institutional investors who can afford larger minimum buy-ins.

The average cost of the three ETFs that follow the S&P 500 is 0.08%. On a $1,000 investment, that’s 80 cents per year for the ETF versus $4 a year for the traditional index fund. That’s not a lot, but all else being equal, why pay more? And if, like many investors, you’re also in actively managed mutual funds, which have higher costs than index funds on average, then your potential savings are even bigger.

“If there’s anything we can say definitively about fund performance it’s that cheaper funds typically do better over more expensive funds over the long term,” said Michael Rawson, an ETF analyst with Morningstar in Chicago.

Weighing the costs

ETFs aren’t always cheaper than the cheapest index funds, however. For example, the expense ratio for Vanguard Group’s Developed Markets Index Fund
VDMIX
is 0.1% versus 0.4% for the iShares MSCI EAFE Index ETF
EFA, -0.22%
which tracks the same index, according to Morningstar.

Expense ratios aren’t everything, though. That Vanguard fund has a $3,000 investment minimum and a redemption fee of 2% if it’s sold within two months, Rawson said, while the iShares ETF has no redemption fee or minimum.

Then again, you may incur trading costs with ETFs, which trade like stocks. For people who buy infrequently and hold, that’s not a big deal. But if you’re buying into the market on a regular basis — sending money from every paycheck to your account, say — those costs add up fast.

Discount brokers offer low-cost trades, and some brokerages, including Vanguard, Charles Schwab and Fidelity Investments, now offer free trades on some products. But you won’t get access to all ETFs for free.

Schwab offers free trades on its 11 proprietary ETFs. Fidelity does so on 25 iShares ETFs. Vanguard provides free trades on its more than 60 ETFs.

For investors who are mainly in actively managed funds, but are leery of ETFs’ trading costs because they invest small amounts regularly, Tom Lydon, editor of ETF Trends, suggested this option: Move your current portfolio into a matching asset allocation of ETFs. Then continue your frequent purchases into traditional funds. At the end of each year, consider another move into ETFs, he said.

If you’re in actively managed mutual funds now, using that strategy, “you could probably assume you’d save more than 1% a year in expenses,” Lydon said. However, if you have a taxable account with large unrealized gains, consider the tax consequences first.

While both index funds and ETFs can help average investors reach their goals in a cost-efficient way, “the one meaningful difference and the one that gives ETFs a real advantage is the tax impact,” said Jerry Miccolis, chief investment officer at Brinton Eaton, a wealth advisory firm in Madison, N.J. Watch video on investing mistakes to avoid.

Owners of traditional funds, index or otherwise, in taxable accounts may face capital-gains taxes when the manager sells securities to pay investors who leave the fund. That’s unlikely with ETFs. Here’s why: When you invest in an ETF, behind the scenes an institutional buyer creates the share units you’re buying. Investors who exit in effect deal with those institutions; the fund doesn’t need to sell anything in general.

“It’s almost as if you had your own dedicated lot of underlying securities,” Miccolis said, and it doesn’t get touched until you sell. “It’s not really a dedicated lot, but in effect that’s the way it works.”

Complicated options

For some investors, access to a diverse array of investments is a key attraction of ETFs. There are more than 1,065 ETFs trading on U.S. exchanges, compared with 323 regular index funds, according to Morningstar. But proceed carefully.

One potential pitfall: severe market volatility, as when the Dow Jones Industrial Average swooned 1,000 points in midday trading during the May 6 “flash crash.” Such volatility will hit ETFs, which trade throughout the day, in a way that it doesn’t traditional mutual funds.

Investors who rely on market orders, which essentially are a direction to the broker to buy the stock at the next available price, can add uncertainty in a fast-moving market; the next available price may differ widely from investors’ expectations.

Instead, ETF investors should use limit orders, said Rick Genoni, Vanguard’s head of ETF product management.

“Limit orders mean you will buy and sell at a given price or better. That protects you,” he said. “Market orders and stop-loss orders didn’t cause the flash crash, but investors using those order types certainly felt the downside risk that comes with those order types,” he said.

“When a market is moving that quickly, a market order is very dangerous,” he said. “Professional traders only use limit orders.”

Also, investors should be wary of leveraged ETFs, which may promise to double the daily return of a particular index. Investors who hold leveraged ETFs over the long haul, rather than buying and selling often, are likely to lose money. They are “not for the amateur investor,” Miccolis said. “They are useful for people who are in and out of the market very frequently.”

Experts also warn that some investors may not fully understand commodity ETFs. “Often when people look at a commodity ETF like a natural-gas ETF, they assume that’s going to give out the exact price performance of natural gas,” Rawson said, “but it actually may invest in natural-gas futures, which are subject to their own idiosyncracies.”

Meanwhile, a broad commodity index may include futures contracts for gold, oil and aluminum. But “all commodities don’t go up and go down at the same time,” said Lydon of ETF Trends. “They don’t all have the same fundamentals and market conditions working for them.”

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